Causes and effects of
inflation
Topic objectives
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Define and explain the causes of Demand
pull inflation
Define and explain the causes of Demand
pull inflation
Demand Pull Inflation
Demand –pull inflation –When there is excess
AD for goods and services
–i.e. a positive output gap (where actual GDP >
Potential GDP)
–Businesses respond by raising prices to
increase their profit margins
–Demand-pull inflation associated with the boom
phase of the cycle (when SRAS becomes
inelastic)
–Root causes of demand pull inflation are usually
monetary in origin
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So, what causes it?
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A depreciation of the exchange rate
A reduction in direct or indirect taxation. If
direct taxes are reduced consumers will have
more disposable income causing demand to
rise
Rapid growth of the money supply as a
consequence of increased bank and building
society borrowing
Rising consumer confidence and an increase
in the rate of growth of house prices
Asset price inflation –e.g. in the housing sector
Faster economic growth in other countries –
providing a boost to UK exports overseas
Illustration of Demand pull inflation
Then SRAS….
And using a non-linear SRAS
Cost push inflation
Causes:–External shocks (commodity
price fluctuations)
–A depreciation in the exchange rate
–Acceleration in wages / unit labour costs
•Leads to inward shift in SRAS
•Firms raise prices to protect their profit
margins –better able to do this when demand
is price inelastic
•“Wages often follow prices”
•Rise in actual inflation can lead to an
increase in inflationary expectations
Illustrating cost-push inflation
Cost push with a non-linear SRAS
The costs of inflation
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‘Taken together, the verdict of economics,
history and common sense is that inflation
and deflation are costly. It is clear that very
high inflation –in extreme cases
hyperinflation –can lead to a breakdown of
the economy [or society]. There is now a
considerable body of empirical evidence
that inflation and output growth are
negatively correlated in high-inflation
countries. For inflation rates in single
figures, the impact of inflation on growth is
less clear.’
•Mervyn King adapted from a speech entitled “The Inflation Target –Ten Years On” given in
2002
Costs and consequences
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Money loses its value and people
lose confidence in money as the
value of savings is reduced
Inflation can get out of control -price
increases lead to higher wage
demands as people try to maintain
their living standards. This is known
as a wage-price spiral.
Employees in poor bargaining
positions lose out
Costs and consequences
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Inflation can favour borrowers at the
expense of savers –because inflation
erodes the real value of existing debts
Inflation can disrupt business planning
and lead to lower investment
Deterioration in global competitiveness
A possible cause of higher
unemployment
Rising inflation is associated with higher
policy interest rates -this reduces trend
growth
Anticipated Vs unanticipated
Anticipated inflation:
–When people are able to make accurate
predictions of inflation, they can take steps to
protect themselves from its effects
–For example, trade unions may exercise their
collective bargaining power to negotiate with
employers for increases in money wages so as to
protect the real wages of union members
Anticipated Vs unanticipated
Unanticipated inflation:
–Unanticipated inflation occurs when
economic agents (people, businesses
and governments) make errors in their
inflation forecasts
–Actual inflation may end up well below, or
significantly above expectations causing
losses in real incomes and a
redistribution of income and wealth from
one group in society to another
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Some web resources
And, again, in diagrams
continued
…
…
Advantages of PD
Some consumers are brought into the market who might
not have been able to afford the product
E.g. lower income consumers / Cheaper anti-viral drugs for
consumers in developing countries
 Social benefits?
 Higher total output than under a single price monopoly
 Profits may finance research and development projects –
dynamic efficiency?
 Profits may help to cross-subsidise other activities
E.g. postal service profits from business mail helps to
maintain the uniform national postal rates
 Doctors might charge lower income patients less –
supported by higher charges for wealthier patients
 Consider impact on allocative and productive efficiency
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Is this a realistic model of
behaviour?
Firms are assumed to know the shape and
location of their cost and demand curves
Firms then chose price and/or quantity to maximise
their desired objective
 In the real world business environment firms will
not be aware of the exact shape of their cost
and revenue curves.
 And they face uncertainty –e.g. about the likely
reaction of other suppliers in the market
 There are many different reasons for price
differences for essentially the same product –not
all of them are to do with price elasticity of
demand!
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Video presentation
Why popcorn costs so much at the
movies
Another video explanation
Further reading…